Right now, the law sets an unfair tax trap for company founders.
The 83(b) Election Tax Trap
When founders come together to form a startup, they usually put vesting on their shares. They do this for tax reasons.
Here are the tax reasons to put vesting on shares: When a company issues stock to a service provider, the service provider’s receipt of the stock is taxable to the service provider.
For example, if you joined a company, and the company wanted to pay you in stock for services performed (say, 10,000 shares for each calendar quarter of service), you would have a problem. Each time the company issued you shares, you would owe taxes on the value of the shares received. This would be the case even if you couldn’t sell the shares to pay the tax (private company shares can’t be re-sold, generally).
This is a flaw in our income tax code, but it is a flaw that shows no signs of being fixed.
How Do Founder’s Get Out of this Mess?
The tax code is not entirely anti-founder. It gives them an out. Here is how it works:
Instead of the company paying you 10,000 in shares for each calendar quarter of services, the company will issue you all of the shares up front, so that you can pay tax on them now, at today’s value. But the company will retain the right to repurchase them at the price you paid if you leave before your service period is expected to end. Typically this right to repurchase at the price you paid lapses monthly over the vesting period, usually with a cliff vesting period at the front end.
This is a nifty tax trick. If the shares are worth a small amount of money now, because the company was just formed, you can pay tax today (and hopefully not very much).
But to not pay tax when the shares vest, you have to file an 83(b) election with the IRS within 30 days of receiving the shares subject to vesting.
The 83(b) election is the only way to avoid a terrible tax outcome when vesting conditions are imposed on founder shares.
If a founder files the 83(b) election with the IRS within 30 days of receiving his or her shares, the founder won’t have any more tax consequences associated with their shares until they sell them. If they hold them for more than a year and sell them, any gains will be taxed as long-term capital gain.
If the founder misses the 30 day deadline, each time their shares vest they will owe ordinary income tax if the value of the shares has increased. This affects not only the founder adversely, but also the company, which must withhold and remit taxes to the IRS if the founder is considered an employee for federal income tax purposes.
Why does the tax code treat founders this way? In almost all instances when an 83(b) election is filed, no additional taxes are due. The 83(b) tax is a tax on the unprepared or the un-initiated. As such, it is not fair tax policy.
I have written that Congress should amend Section 83(b) to reverse its presumption. In other words, deem the election made if at the time of receipt of the shares no additional tax would be owed, because the person paid FMV for their shares.
There are other simple fixes too. How about just require the attachment of the 83(b) election to the Form 1040 for the year? In other words, delete the 30 day filing requirement?
Or, how about this? Allow electronic filing of 83(b) elections. Right now, the tax code and regulations are silent on whether electronic signatures on Section 83(b) elections work. This is a shame. The result is that to be safe, the recommended advice is to file origanally signed elections, which makes these elections more difficult to file. Some companies, such as eShares, are taking the position that electronic signatures will not be disputed by the IRS. I applaud the approach. But if we have a pro-business administration right now, the very least that ought to happen is the IRS ought to publish guidance that electronic signatures are completely acceptable in this context.